Friends Company, a manufacturer of valves, produces and sells two types of valves: Gas Safety Valves (GSV) and MSC Valves (MSC). Friends Company has the following data for the two products:

In addition, Friends Company has identified the following activities, costs, and activity consumption cost drivers:

Friends Company also collected the activity data for each product:

Using the total cost for each activity and the total amount of activity cost driver we can determine the activity cost rate:

As we can see from the table above, one set-up costs $294.12, one machine-hour costs $7.41, one inspection-hour costs $10.00, and one packing order costs $5.36. Now, let’s calculate the per-unit cost of each product manufactured by Friends Company:

The allocation of factory overhead using activity-based costing is summarized in the illustration below.

Illustration 4: Friends Company’s allocation of factory overhead costs using ABC

Using the obtained data we can perform the product profitability analysis; that is, we will determine the unit margin profit of each product:

According to the data presented in the table above, the MSC product is actually $22.57 ($37.18 – $14.61) less profitable than the GSV product. The unit margin percentage for the MSC product is lower than the one for the GSV product when using the activity-based costing. Therefore, the management of Friends Company might consider changing the production process of the MSC product (e.g. increase batch-size to decrease the cost of machine set-ups per item produced) and increasing the selling price (i.e. as long as the increase in selling price would not substantially decrease product sales).

Using this example we can see that activity-based costing provides a lot of information about production activities and how they affect the cost of products, which the volume-based costing system does not explain.

Let’s compare the product profitability analyses under volume-based and activity-based costing:

As we can see from the table above, the product per-unit cost and per-unit margin profit differ under the volume-based and activity-based costing. The reason is that activity-based costing traces overhead consumption by each product and thus provides a more accurate per-unit overhead cost.

On the other hand, volume-based costing assigns factory overhead costs using direct labor-hours or machine-hours as a cost driver. As the result, volume-based costing undercosts low-volume product (i.e. products requiring fewer direct labor hours in total) and overcosts high-volume products (i.e. products requiring more direct labor-hours in total). In our example, the production of GSV product and MSC product required 30,000 and 20,000 direct labor-hours, respectively. Therefore, the overhead per unit cost for products GSV and MSC were overstated and understated, accordingly.

Using the data obtained under the activity-based costing, for example, we can see that the overhead per-unit cost of product GSV is overstated by $16.18 (i.e. $16.18 = $36.00 – $19.82) under the volume-based costing because the production of GSV requires more direct labor-hours (in total). Thus, a product – MSC in this case – is subsidized at the expense of others. In cost accounting this is called cross-subsidization.